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I was pleased to see Treasury and the IRS finally release some
guidance under §901(m) – and in less than four years since its August 2010
enactment and January 2011 effective date. Not exactly record pace but better
than many other areas. However, upon reading
Notice 2014-44, I have to admit disappointment at both the scope and the
direction taken by the government.

As we all know, §901(m) has the purpose and effect of denying
foreign tax credits for foreign income taxes that are considered paid because
deductions available for U.S. tax purposes as a result of a covered asset
acquisition (deductions that reduce either earnings and profits (E&P) or
U.S. taxable income) are not available for foreign income tax purposes. A
covered asset acquisition occurs when there is an asset step-up for U.S. tax
purposes, such as under a §338 election or a deemed transfer of assets in the
check-the-box context. Section 901(m) is intended to neutralize the potential
foreign tax credit "hyping" effect in situations where E&P or
U.S. taxable income deductions exceed the deductions available for foreign tax
purposes.

In a prior commentary on covered asset acquisitions in 2011, I
pointed out (some might say there was some whining involved) a number of areas
where I hoped Treasury and IRS guidance would be forthcoming. My focus
consisted primarily of concerns about the potential for double taxation and the
complexity from an administrative standpoint.
My main point on potential double taxation was with respect to the
inclusion as a covered asset acquisition subject to §901(m) of a §338 election
or a §754 election with respect to a U.S. target company or U.S. partnership
with a foreign branch. In those cases, U.S. versus foreign tax basis
differences result, but it is also true that taxable income is accelerated for
U.S. tax purposes. For example, in the
case of a U.S. target company, the target company pays U.S. tax on the
underlying appreciation in its foreign branch assets immediately as a result of
the §338 election, it obtains no step-up in the basis of its assets for foreign
tax purposes, the future U.S. taxable income with respect to those assets
should be reduced by increased deductions such as §197 amortization with
respect to the basis step-up over time, and the effective foreign tax rate in
future years could exceed the nominal rate due to the higher U.S. tax
deductions compared to the deductions used in computing foreign taxable income
(based on historic bases). To deny a foreign tax credit for the portion of
foreign tax attributable to such basis differences would seem highly
inequitable, indeed a form of double tax. I was hoping to see this covered in
the Notice so I am raising it again now to remind Treasury and the IRS to
consider it in their next set of guidance.

My main point on complexity related to the calculation of the basis
differences in a covered asset acquisition — the statutory language requires
calculation of the pre-acquisition U.S. basis of a target's assets. One of the
biggest benefits of a §338 election with respect to a foreign target is to
expunge the E&P and basis history of the target and get a fresh start for
U.S. E&P, foreign tax credit, and Subpart F purposes. Many of my clients
are willing to accept a likely step-down in order to get that simplification,
which would seem easy enough for the government to offer through, say, an
election to use pre-acquisition foreign book value as a proxy for U.S. tax
basis. But, as above, I was disappointed that this was not offered in the
Notice, which in fact explicitly refers to pre-acquisition U.S. tax basis. So
consider this another reminder of my earlier suggestion.

What the Notice does cover is a narrow focus on what the IRS
perceives as a potential loophole position purportedly taken by "some
taxpayers" with respect to the disposition rule in the statute. The
mechanics of the foreign tax credit disallowance are contained in §901(m)(3)
and define the disqualified portion of a foreign income tax as the tax amount
multiplied by a ratio, the numerator of which is the portion of the aggregate
basis difference applicable to a particular year (computed under U.S. tax
principles) and the denominator of which is the foreign taxable base for that
year (computed under foreign tax principles). For example, assume a §338 step-up
of a foreign target with the full step-up allocated to goodwill. The numerator
for a given year would reflect a one-fifteenth §197 amortization amount and the
denominator would reflect foreign taxable income obviously without the benefit
of the §197 deduction. In theory, this
would neutralize the perceived foreign tax credit "hype" being
created by the additional E&P deduction. In practice, one can imagine all
sorts of anomalies in the calculation of the U.S.-tax-principles-based basis
difference and the foreign country taxable income that will distort the result
one way or the other. But I am digressing …

The disposition rule in §901(m)(3)(B)(ii) provides that on the
disposition of a relevant foreign asset, which is one in which there is a
U.S.-versus-foreign basis difference, the numerator of the above fraction would
reflect the full remaining basis difference such that no further basis
difference would remain and therefore there would be no future year's foreign
tax disallowance. Seems like reasonable
policy. If the foreign goodwill in my example above was disposed of, in that
year the remaining basis difference would be accounted for and the §901(m)
impact with respect to that foreign asset would end in that year.

The question is what constitutes a disposition? There is no guidance
in the statute. Analogous authority would support viewing the term quite
broadly — a transaction where the taxpayer or entity no longer owns the asset
would seem like it must constitute a disposition. A reasonable question might
be whether the term "disposition" should be interpreted by analyzing
it from a U.S. or foreign country context or both, i.e., has there been a
disposition for foreign tax or legal purposes or for U.S. tax or legal
purposes. Because the focus of the provision is on the amount of foreign tax
eligible for U.S. credit, I was thinking that if the term
"disposition" were to be limited to one or the other, it should be
considered in the foreign context — was there a disposal resulting in a new owner
for foreign tax or legal purposes. However, the Notice indicates that the
purported interpretation that was troubling to Treasury and the IRS was the
making of a check-the-box election on a foreign target after a §338 election
with the view that a disposition had occurred because the relevant foreign
assets were then held by a different controlled foreign corporation for U.S.
tax purposes. Admittedly, if a check-the-box election constitutes a disposal
for this purpose, §901(m)'s potential impact could be severely curtailed.

While the statute does not contain a definition of
"disposition," the Notice points out that the Joint Committee on
Taxation's technical explanation of §901(m) included the following:However it
is intended that this provision generally apply in circumstances in which there
is a disposition of the relevant foreign asset and the associated income or
gain is taken into account for purposes of determining foreign income tax in
the relevant jurisdiction.

The Notice takes this approach and limits the reach of the
disposition provision to apply only to the extent that there is a realization
event for foreign tax purposes. A much narrower view than my foreign ownership
change approach, which is hard to read into the words of the statute but is
supported by the JCT language and the statute does include the invitation
"except as provided in regulations". A realization event for foreign
tax purposes is broadly defined in the Notice to include a sale, abandonment,
or even a mark-to-market event. So the focus is merely on the foreign tax gain
recognition treatment and not on there being a "disposition" as one
might ordinarily think of it.

Absent a foreign taxable event, the §901(m) basis difference and the
required foreign tax disallowance continue, even in the case of a
"disposition" for U.S. tax or foreign legal purposes to an unrelated
party. Thus, in the case of a reorg, formation of a joint venture, sale of a
foreign target, etc., the §901(m) taint would carry over. Presumably, the
§901(m) taint could even pre-date U.S. ownership because at any point in time
after 2010 a covered asset acquisition basis difference could arise when one
must compute historic U.S. tax basis. One thinks of a covered asset acquisition
only in terms of a direct or indirect U.S. acquirer that has §338 or
check-the-box elections available. However, a pre-U.S. ownership,
foreign-to-foreign acquisition by a foreign corporation of an unlimited
liability foreign target company that defaults to a flow-through entity under
U.S. rules would be one event that would seem to create a foreign-owner covered
asset acquisition. I have no doubt subchapter K could produce other examples in
the same vein. The point of concern is
the need for more diligence given the risk and complexity in assessing the U.S.
tax basis and E&P history of any foreign target and the potential traps for
the unwary that can lurk. So much for the tidiness of the §338 purge.

Section 901(m)(3)(B)(ii) grants specific authority to provide
exceptions and §901(m)(7) grants broad regulatory authority so one would assume
the provisions of the Notice are likely to be considered valid. The effective
date is with respect to dispositions on or after July 21, 2014, with the usual
caveat that no inference is intended regarding the treatment of transactions
under current law. It is hard for me to see this very specific rule having
retroactive effect, especially as §901(m)(3)(B)(ii) specifically authorizes the
provision of exceptions by Treasury and the IRS. In this regard, the Notice
uses the heading "Concerns with Statutory Disposition Rule," which
seemingly signals that the narrowing of the disposition concept was intended as
an exception to the statutory rule. And the use of a check-the-box election in
the example would be further evidence that dispositions for either U.S. or
foreign tax or legal purposes were dispositions before the Notice. So a broader
view of dispositions seems appropriate for pre-Notice periods. Because
check-the-box elections can be made with 75-day retrospective effect, I
considered the opportunity to help clients qualify for the broader application
of the disposition rule by acting quickly after the Notice if indeed a
check-the-box election that would be effective pre-July 21 was available (e.g.,
the entity was not a per se entity) and was not otherwise detrimental in
their overall corporate structure. But I guess I wasn't the only one
considering that opportunity because as I was finalizing this commentary I read
the government's follow-on Notice 2014-45, which applies the stricter foreign
gain recognition concept in defining dispositions including for any
check-the-box elections that are filed after July 29, 2014. So it seems
that only clients that had a transfer for foreign purposes or a U.S.
check-the-box election before the first Notice or that were very very quick
with a check-the-box election after the first Notice would be in a position to
avoid the more onerous rule. I would note that this is the first time I have
seen Treasury and the IRS consider the date of filing an election that has
earlier effect to be the pivotal date. Another potentially troubling sign of
possible things to come. And another reason not to dawdle and remember that
fortune favors the swift!

Speaking of swift, back to my point at the start of this commentary
about this guidance that was four years in the making. The exceedingly narrow
scope of the Notice is a disappointment.
There is a lot in §901(m) that needs guidance and a good bit that really
needs fixing in order to be practical or at least workable. The grant of broad regulatory authority ought
to be viewed not only as an opportunity to close perceived loopholes but also
as a responsibility to provide needed guidance.

This commentary also will appear in the September 2014 issue of
the Tax Management International
Journal. For more information, in the
Tax Management Portfolios, see DuPuy and Dolan, 901 T.M., The Creditability
of Foreign Taxes -- General Issues, and in Tax Practice Series, see ¶7150, U.S.
Persons — Worldwide Taxation.

The views expressed herein are those of the
author and do not necessarily reflect those of Ernst & Young LLP.

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